SECTION 9 Review

Module 46

1. Changes in the price of a good affect the quantity consumed as a result of the substitution effect, and in some cases the income effect. Most goods absorb only a small share of a consumer’s spending; for these goods, only the substitution effect—buying less of the good that has become relatively more expensive and more of the good that has become relatively cheaper—is significant. The income effect becomes substantial when there is a change in the price of a good that absorbs a large share of a consumer’s spending, thereby changing the purchasing power of the consumer’s income.

2. Many economic questions depend on the size of consumer or producer responses to changes in prices or other variables. Elasticity is a general measure of responsiveness that can be used to answer such questions.

3. The price elasticity of demand—the percent change in the quantity demanded divided by the percent change in the price (dropping the minus sign)—is a measure of the responsiveness of the quantity demanded to changes in the price. In practical calculations, it is usually best to use the midpoint method, which calculates percent changes in prices and quantities based on the average of the initial and final values.

Module 47

4. Demand can fall anywhere in the range from perfectly inelastic, meaning the quantity demanded is unaffected by the price, to perfectly elastic, meaning there is a unique price at which consumers will buy as much or as little as they are offered. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line.

5. The price elasticity of demand is classified according to whether it is more or less than 1. If it is greater than 1, demand is elastic; if it is less than 1, demand is inelastic; if it is exactly 1, demand is unit-elastic. This classification determines how total revenue, the total value of sales, changes when the price changes. If demand is elastic, total revenue falls when the price increases and rises when the price decreases. If demand is inelastic, total revenue rises when the price increases and falls when the price decreases.

6. The price elasticity of demand depends on whether there are close substitutes for the good in question, whether the good is a necessity or a luxury, the share of income spent on the good, and the length of time that has elapsed since the price change.

Module 48

7. The cross-price elasticity of demand measures the effect of a change in one good’s price on the quantity of another good demanded. The cross-price elasticity of demand can be positive, in which case the goods are substitutes, or negative, in which case they are complements.

8. The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in income. The income elasticity of demand indicates how intensely the demand for a good responds to changes in income. It can be negative; in that case the good is an inferior good. Goods with positive income elasticities of demand are normal goods. If the income elasticity is greater than 1, a good is income-elastic; if it is positive and less than 1, the good is income-inelastic.

9. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line.

10. The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and when more time has elapsed since the price change.

Module 49

11. The willingness to pay of each individual consumer determines the shape of the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus.

12. Total consumer surplus in a market, which is the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. The term consumer surplus is often used to refer to both individual and total consumer surplus.

13. The cost of each potential producer of a good, the lowest price at which he or she is willing to supply a unit of that good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus.

14. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. A rise in the price of a good increases producer surplus; a fall in the price reduces producer surplus. The term producer surplus is often used to refer to both individual and total producer surplus.

Module 50

15. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus.

16. Usually, markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society.

17. A tax that rises more than in proportion to income is a progressive tax. A tax that rises less than in proportion to income is a regressive tax. A tax that rises in proportion to income is, you guessed it, a proportional tax.

18. An excise tax—a tax on the purchase or sale of a good—raises the price paid by consumers and reduces the price received by producers, driving a wedge between the two. Tax incidence—how the burden of the tax is divided between consumers and producers—does not depend on who officially pays the tax.

19. The incidence of an excise tax depends on the price elasticities of supply and demand. If the price elasticity of demand is higher than the price elasticity of supply, the tax falls mainly on producers; if the price elasticity of supply is higher than the price elasticity of demand, the tax falls mainly on consumers.

20. The tax revenue generated by a tax depends on the tax rate and on the number of units sold with the tax. Excise taxes cause inefficiency in the form of deadweight loss because they discourage some mutually beneficial transactions. Taxes also impose administrative costs: resources used to collect the tax, to pay it (over and above the amount of the tax), and to evade it.

21. An excise tax generates revenue for the government but lowers total surplus. The loss in total surplus exceeds the tax revenue, resulting in a deadweight loss to society. This deadweight loss is represented by a triangle, the area of which equals the value of the transactions discouraged by the tax. The greater the elasticity of demand or supply, or both, the larger the deadweight loss from a tax. If either demand or supply is perfectly inelastic, there is no deadweight loss from a tax.

22. A lump-sum tax is a tax of a fixed amount paid by all taxpayers. Because a lump-sum tax does not depend on the behavior of taxpayers, it does not discourage mutually beneficial transactions and therefore causes no deadweight loss.

Module 51

23. Consumers maximize a measure of satisfaction called utility. We measure utility in hypothetical units called utils.

24. A good’s or service’s marginal utility is the additional utility generated by consuming one more unit of the good or service. We usually assume that the principle of diminishing marginal utility holds: consumption of another unit of a good or service yields less additional utility than the previous unit. As a result, the marginal utility curve slopes downward.

25. A budget constraint limits a consumer’s spending to no more than his or her income. It defines the consumer’s consumption possibilities, the set of all affordable consumption bundles. A consumer who spends all of his or her income will choose a consumption bundle on the budget line. An individual chooses the consumption bundle that maximizes total utility, the optimal consumption bundle.

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26. We use marginal analysis to find the optimal consumption bundle by analyzing how to allocate the marginal dollar. According to the optimal consumption rule, with the optimal consumption bundle, the marginal utility per dollar spent on each good and service—the marginal utility of a good divided by its price—is the same.